Income producing financial products are important components in the investment portfolios of millions of investors. Such products currently include single credit products such as certificates of deposit (CDs), bonds and preferred stocks. They also include multiple credit products like mutual funds and Unit Investment Trusts.
An ideal fixed income investment for many investors would provide secure periodic payments at a substantially constant rate of return over an extended period of time. The investment would be efficient to administer, tax efficient, and diversified. Advantageously, the investment would be founded on assets of quality known to the investors and would itself be an investment of quality known to the investors. Preferably the product would be available in small denominations accessible to the general public, would be liquid, and would resemble a bond. Unfortunately the currently available single credit and multiple credit fixed income products fall significantly short of this ideal.
Bonds are fixed income instruments that represent debt obligations of the issuer of the bond. They pay interest and return principal at a maturity date. Interest is generally paid semi-annually in cash, and the rate of interest usually reflects the credit risk of the issuer and the length of the term of the bond (maturity dates may extend as long as 100 years). In many cases, the credit risk of the issuer is denoted by the credit rating of the bond.
Bonds come in many forms and are issued by different parties. Among the more common forms are: (i) municipal bonds, typically exempt from certain taxes levied upon interest payments, (ii) government bonds, typically issued by a sovereign issuer like the United States, (iii) corporate bonds, typically issued by a corporation or limited partnership, and (iv) zero-coupon bonds, which usually pay interest in lump sum at a future date.
As noted, the credit risk associated with a bond is highlighted by its credit rating. A credit rating attempts to measure the likelihood that a bond continues to pay interest and returns principal at maturity. Bonds that have a lower probability of default are generally called “investment grade rated” (for example, the United States is AAA rated, reflecting the very low probability of default) and bonds that have a higher probability of default are “non-investment grade” or are considered “high yield” investments because the interest paid to investors must be greater to justify the increased risk of default. An investment grade bond is rated BBB−/Baa3 or above by S&P/Moody's. A non-investment grade is rated BB+/Ba1 or below.
Individual bonds, however, are not ideal fixed income investments. Government bonds are relatively risk free but tend to pay relatively low interest rates. Corporate bonds tend to pay higher interest rates but are subject to the risk of default by the issuer. Default risk can be reduced by diversification, but the investment required for adequate diversification may be beyond the means of many individual investors. Bonds typically have minimum denominations of $1000, and acquiring several can be expensive and affect the asset allocation of a modest portfolio. In addition, many corporate and some government and municipal bonds are subject to call provisions whereby the issuer has the right to redeem the bond prior to maturity. The investor receives the specified call price, but typically must reinvest at a less favorable interest rate.
Certificates of deposit (“CDs”) or bank notes usually take the form of time deposits at financial institutions that offer an investor a fixed rate of return over the term of the CD or bank note. A common feature of these instruments is FDIC insurance that may cushion an investor from loss in the event of a default on payment of interest or return of principal by the financial institution.
CDs do not provide secure income over an extended period. They must be periodically rolled over at new prevailing interest rates. The rates available at rollover can vary dramatically. Moreover, CDs do not typically provide the periodic monthly or quarterly payments sought by many investors.
Preferred stock is an instrument typically issued by corporations or financial institutions that is subordinate to senior instruments such as bonds and CDs. Subordination refers to the priority of a preferred holder's claim against the issuer of the preferred stock should the issuer default on an interest payment or fail to return principal. A preferred stock holder's priority in bankruptcy falls behind the claim(s) of senior bond holder(s), and thus the credit risk associated with preferred stock is viewed as greater than the credit risk associated with bonds.
Some preferred instruments have maturity dates and others are perpetual. In addition, some preferred instruments have voting rights and features such as optional interest deferral clauses (allowing an issuer to stop paying interest for a period of time). Furthermore, some preferred securities (such as trust preferred) are considered debt instruments for tax purposes and others are considered equity instruments for tax purposes. In sum, the characteristics of preferred instruments vary widely, but one feature that typically exists in each instrument is risk due to subordination to senior instruments.
We now turn to the features and shortcomings of existing multiple credit fixed income products.
Mutual funds are popular products that exist pursuant to the provisions of the Investment Company Act of 1940 (the “1940 Act”). The premise of most mutual funds is asset diversification. Mutual funds were designed to enable investors to purchase investment units or shares in funds that hold a pool of assets. By purchasing an ownership interest in a fund, investors may be better sheltered from volatility and loss because their capital is invested across multiple institutions in debt, preferred and/or equity instruments. Mutual funds can be managed to track an index (like the S&P 500) or to pursue an investment strategy, such as a balanced return. A balanced fund might invest in both bonds and stocks in an attempt to mix the returns of bonds and stocks to better balance returns from the two asset classes. The income generated on investments (after management fees) and then distributed to fund holders is often variable and unpredictable. In addition, mutual fund shares are often not rated by a nationally recognized rating agency, though some of the assets that mutual funds invest in may be rated.
Mutual funds are exempt from registration under the Securities Act of 1933 (the 1933 Act) if they qualify as investment companies and comply with the rules and guidelines set forth in the 1940 Act. One predominant feature of mutual funds is the use of determinations of net asset value (NAV) to measure the value of the mutual fund shares. Usually at the end of each day, a mutual fund will calculate the net asset value of a mutual fund share. This calculation essentially prices the mutual fund shares by adding the fair market values of the assets held, deducting for costs, expenses or other liabilities, and then dividing by the number of outstanding mutual fund shares. If an investor would like to “sell” a mutual fund share, the investor contacts the mutual fund manager to redeem the mutual fund shares at a value approximating the net asset value. Therefore, mutual fund shares are usually purchased and sold through the redemption process, not traded on an exchange.
To summarize, the important highlights of typical mutual funds are: (i) creation pursuant to and in compliance with the 1940 Act (general exemption from the 1933 Act), (ii) net asset value as a measure of the price of a share, (iii) active management of the assets, and (iv) share redemption (as opposed to exchange-traded).
Mutual funds, as millions of investors are aware, do not provide either a secure stream of income or a secure return of investment. Income varies, NAV fluctuates, management fees can be significant, turnover can be tax inefficient, and the nature and quality of the fund investment portfolio can stray from initial objectives.
Unit Investment Trusts (“UITs”) are also created pursuant to the 1940 Act. Like mutual funds, UITs are diversified investments that enable investors to purchase units that entitle them to fractional ownership of a pool of assets. Similarly, they are subject to the net asset value calculations typical of mutual funds and have sponsors that select the assets in the pool. Like mutual funds, UIT shares are often not rated, though some of the assets that UITs invest in may be rated.
However, unlike mutual funds, UITs tend to be passively managed. In other words, UIT sponsors are typically restricted in their ability to manage (or buy and sell) assets. This lack of management capability generally runs contrary to most mutual funds. As a result, UITs usually take the form of static pools of assets and the underlying securities in the pool do not change with frequency. However, as with mutual funds, the periodic rate paid to holders of UITs is typically not constant.
Accordingly, there is a substantial and unmet need for an improved fixed income product.